This article was written by Matthew Dennis, senior portfolio manager for Invesco international/global growth products.
International markets experienced increased volatility in the second quarter: Equity volatility rose by 19% in the US and by 50% in Europe.1 Notwithstanding a fade in equity volatility in July on the back of a perceived solution to the Greek crisis, bond market volatility has remained elevated. As we look ahead to the remainder of 2015, reading the tea leaves of the market remains challenging. At the highest level, there are two key questions we remain focused on:
- Is volatility risk rising, stable or declining, and how are equity valuations able to withstand it?
- Is the path of least resistance for global growth improving or eroding?
Volatility risk remains high
To the first question: We think volatility risk remains above average and, in most instances, valuations are too rich to provide adequate protection during sharp bursts of volatility.
We believe higher volatility is generally good for the Invesco International and Global Growth strategies given our quality bias and an active management process that seeks to consistently exploit volatility. As part of this process:
- The strategies diversify exposure by avoiding unnecessarily large positions in stocks, industries and countries — to help mitigate excessive risk.
- We analyze individual businesses through our earnings, quality and valuation (EQV) filter. This disciplined process enables us to avoid getting distracted by short-term noise.
- We shun high-valuation glamor stocks and seek businesses that are sustainable, demonstrate positive repeatable results, and have high visibility and durable competitive advantages.
Global growth is taking two distinct paths
To the second question: There’s a case to be made by bears and bulls alike.
Growth bears point to the slowdown in China and emerging markets and the carnage in commodities:
- China is cutting rates on the back of decelerating gross domestic product growth and ineffective government efforts to arrest the decline in Chinese equities.
- Southeast Asian economies remain fragile given their dependency on commodities, in many instances, as well as their trade with China.
- The situation in Brazil is just plain bad and getting worse. Brazil’s announced fiscal budget cut raised concerns about the government’s ability to stabilize debt and fueled speculation about a rating agency downgrade to below investment grade. Meanwhile, its currency depreciated further, unemployment rose, the recession deepened, and inflation continued higher.
- Iron ore prices are down 24% year to date, and down 15% in July alone.2
- Copper prices have hit year-to-date lows and are back to levels last seen in 2009.3
On the other hand, growth bulls will point to positive trends in the developed markets:
- Recovery is taking shape in the eurozone, buoyed by easing monetary conditions.
- Deflation fears are abating based on recent core inflation data and declining gold prices.
- US employment is rising along with accelerating wage growth.
- The US yield curve is steepening.
- Federal Reserve Chair Janet Yellen’s comments have been consistent with the expectation that the Fed will soon raise rates.
- Lower energy prices are seen as a net stimulus to growth.
For now, clarity on the trajectory of global growth remains limited. But here’s what the Invesco International and Global Growth team sees right now:
- Developed world (Europe/US/UK). Growth expectations are improving (in that order). Unfortunately, valuations are pricing in much of the region’s good news.
- Japan. The quality of growth in the country is low, driven more by yen weakness than consumption. Also, the market is expensive, in our view.
- Emerging markets (China/Latin America). Growth expectations are deteriorating rapidly. Valuation opportunities are starting to emerge, but there is a high risk of falling into “value traps” — where an undervalued stock struggles to recover to its former levels.
The world’s growth trajectory has clear implications for how we expect our strategies to perform. In short, we expect that our holdings would see their prices rise in a weak growth environment, as investors would be willing to pay more for companies with growth potential. On the other hand, a high growth environment—in which investors are less risk averse and more willing to pay for low quality and higher volatility stocks – would likely see us lag the market due to our bottom-up approach, which focuses on investing in quality growth companies at attractive prices.
1 Source: Bloomberg LP from March 31, 2015, to June 30, 2015. US equity volatility measured by the CBOE Volatility Index. European equity volatility measured by the VSTOXX.
2 Source: Bloomberg LP as of July 27, 2015